Thursday, December 31, 2015

Some of this might be repetitious, but I have been playing around more with Zillow data, with the 151 largest MSAs which Zillow has data on Rent, Price, and Income going back to about 1986. I hope to pull some more out of this. But, for today, here are some basic graphs. (I am using Excel. I don't know an easy way to do a weighted regression in Excel. Since the extreme examples of recent trends tend to be among the larger cities, these unweighted relationships probably understate the trends.)

Here is a scatterplot of annual Rent/Income and Income (normalized to US median). Up to 1995, we see the pattern that should be intuitive. Households with higher incomes tend to spend a lower portion of their incomes on housing. In 1986 and 1995, this pattern shows up in inter-city trends. Cities with higher incomes tended to spend less on housing. But, in the mid-1990s housing supply started to be the binding constraint for access to lucrative labor markets. So after 1995, we see this unusual new pattern where high rent becomes the entrance fee to a higher income.

Here is a scatterplot of Price/Income and Income. Here, we see that there was no relationship before the mid 1990s. Median home prices were generally a product of other factors and were unrelated to median incomes. After the mid 1990s, we see the same change in trend that we see with rents. In cities where the median household has a higher income, they pay a higher proportion of that income in order to buy a home. Note that if the housing market from 1995 to 2005 was characterized mainly by generous credit to low income households, we would have seen the opposite effect. But, this pattern suggests that home prices increased the most where marginal access to credit should have been less of a factor.

Here is a scatterplot of Price/Income and Rent/Income. Before the mid-1990s, there was a small relationship between these measures. In a pristine textbook world, we should expect the y-axis intercept of this relationship to be near zero. And, if rent is about 25% of incomes and Price is about 250%, we would expect the coefficient to be around 10. Factors like different property tax rates would cause the relationship to be weaker. And, if there was no supply constraint, we might expect rents to revert to the mean, which might also lower the coefficient.

After 1995, the coefficient of relative Price/Rent moves well above 10 and the relationship strengthens dramatically. In 1995, r-squared is .13. By 2015, it is .67! Rising prices in the housing boom and its aftermath are strongly associated with rising rents. This is because the supply constrained cities are associated with rent inflation and with expected future rent inflation. The imposition of local supply constraints means that rent expectations are no long mean reverting. Since the peak of the boom in 2005, constraints in mortgage lending have been an obstacle to new home building, holding prices down (because of the lack of access to capital) but pushing rents up (because of the lack of new supply). So, even while the regression line has moved down and to the right, the relationship between rents and prices has strengthened substantially.

We can see some unusual activity above the norm in 2005 among some cities that did not have unusually high rents or incomes, which points to some areas that saw temporary, and probably unsustainable, price movements at the end of the boom, but that was limited to a small number of smaller markets. The bulk of the country saw little deviation from the norm, and the largest cities have seen persistence in rent increases and a rebound in home prices in the decade since 2005, even in the absence of functional credit markets. We have a big supply problem which for a short period coincided with a small amount of unusual nominal price expansion.

Here is a comparison of Price/Incomes, by city, at each point in time (moving right to left), regressed against both Rent/Income and Relative Income. From 1995 to 2005, during the boom, median home prices in a city became much more correlated with rents, and even after accounting for this, also had a significant positive relationship with income. Even in 2005, even after accounting for what they were spending on rent, the median households in cities with lower incomes were paying significantly less for their homes than the median households in cities with higher incomes. To my eyes, this describes a supply constrained world, and it clearly does not describe a world where generous credit is pulling lower income households into overpriced houses.

Here is a paper (pdf) from Demers and Eisfeldt (HT: Commenter Wd at Arnold Kling's blog) about how total returns to rental home ownership tend to be relatively stable across cities. Where yields are lower, price appreciation has made up the difference. Using Zillow data, I also find that prices across cities have generally been justified by rent cash flows.

Here is a graph of real returns to the median home in each MSA, over time, based on median home prices and median rent in each MSA. For each MSA, I estimated future rents by assuming future rents would rise, in real terms, at the same rate they have risen since 1995. The bold black line is the US average, and the bold red line is the real return on 30 year inflation protected treasury bonds (TIPS). This is similar, but a somewhat more detailed approach, to previous measures I have used.

The first graph is for the largest 20 MSAs and the next graph is for the largest 151 MSAs for which Zillow has data. In both cases, we see fairly reasonable movements over time, with some unusual declines from 2004 to 2007 among a handful of cities. And, we see the divergence between housing returns and TIPS returns after 2007, with housing returns moving to the high end of the long term range and treasuries moving to very low levels.

Two points to keep in mind on these graphs:

1) I have applied a blanket expense ratio of 50% to gross rents. Cities with, say, higher property taxes would require higher gross returns, so that some cities might tend to run higher in this estimate of returns than others, though this shouldn't generally affect trends over time.

2) This is based on the median house over time. In cities with high levels of housing starts, new houses should tend to be more valuable than the existing median house, so my measure probably overstates returns over time, because rents on a particular house will grow at a slightly lower rate than the rent of the median home in the MSA. This effect will be larger in cities with more new housing, so while this probably causes the entire range of returns to be overstated, it also should cause the divergence during the boom to be lower, because cities where there was not as much of a price increase tended to have higher housing starts.﻿

Wednesday, December 30, 2015

The Wall Street Journal has a story about a new bond being issued by the GSEs (HT: Nick Timiraos). They are starting to issue bonds that, as far as I can tell, basically take the default risk when there is a systemic default crisis. This is similar to the CDO securities that collapsed when defaults rose across MBS pools.

This seems like precisely the wrong direction to take. And, I think that this is a good example of how critical one's prior estimation of the robustness of markets is to one's policy conclusions. In an economy with extensive bank regulation and a fiat currency, I submit that systemic risks are, practically by definition, a public problem. If a variety of public institutions have broad influence over the value of the currency, the growth of mortgage lending, and general cyclical banking postures, then the responsibility of systemic risks should be socialized. If you blame the housing bust on private investors and banks, then this must sound like madness. But, even most of the people I hear arguing that the bulk of the expansion was a demand-side bubble are basically building their arguments on public institutions - an overly accommodative Fed, the GSE's, the CRA, etc.

If the sort of proto-Austrian business cycle view that seems to be common is true - that the Fed caused the economy and the housing market to overheat in the 2000s - then why shouldn't taxpayers take the losses? Isn't the idea in that point of view that the "overheating" is an inevitable tragedy-of-the-commons problem? Why should the hapless private investors who are supposedly misled into making suboptimal investments take the loss? Losses should come from individual errors, not from being captive on some public-policy roller coaster.

Now, I don't agree with those assessments of the housing boom. I think any excesses were a fairly small, and late in the cycle, that most of the rising prices were a reflection of supply constraints, and that most of the public errors were errors of demand-deprivation. But, in the end, my position shouldn't lead to a significantly different public posture than the pro-bubble narratives. In both narratives, the responsibility for systemic losses should be social.

I suspect that most of the de facto benefits that might come from having the GSE's come from the fact that, in an economy with a fiat currency, matching balance sheet risks between nominal debts and real collateral is difficult, both because inflation is potentially unanchored, and because nominal shocks can create systemic default events. So, if the GSE's are socially useful, it seems that one of those uses is to take on that default risk. Does anyone believe that we would have been better off in the crisis if the GSE's hadn't absorbed much of those temporary losses?

In private MBS markets, the systemic risk seems like an unavoidable cost. Modern Portfolio Theory is based on the idea that systemic risk earns a premium because it is unavoidable. I don't see how there is even a natural buyer for these bonds. It's not like we have a shortage of systemic risk and institutions are trying to find ways to add more. Institutions earn a premium by taking systemic risk for others.

This is one of the benefits of NGDP level targeting - that it might lower systemic risk, and therefore lower the premium required for risk-taking investments. Thinking about the GSE's in this way, and thinking about the social responsibility for systemic economic issues in a mixed economy, thinking outside the box a bit, maybe government should consider taking on more systemic risk. Maybe we should issue Treasuries and use the public funds to purchases broad shares in equities - like an S&P500 basket, or a Russell or Wilshire total market basket. Maybe the best public investment strategy is to make private investment naturally short on systemic risk and long on idiosyncratic risks. Private investors don't want systemic risk. It pays a premium because it poses a problem. But, also, this would put public institutions in a position of having a strong incentive to avoid systemic crises. Some might argue that we have been privatizing gains and socializing losses. Is there a way to socialize systemic gains while keeping idiosyncratic gains private?

Whatever the answer, and whatever set of adjustments we need to make to our real estate funding conventions, selling bonds on the systemic risks of the GSE pools hardly seems like a helpful change.

Tuesday, December 29, 2015

The forward-looking tendency of markets means that the costs of our policies tend to be captured as the policies are implemented. I have argued that the rise in Price/Rent levels in the Closed Access cities after 1995 was partly a result of the persistence of rent inflation. The expectations of future rent increases gradually fed into higher home prices, much like a growth stock would carry a higher Price/Earnings ratio than the stock of a slowly growing firm.

So, once those expectations are internalized in prices, the existing real estate owners have captured all of the gains of the policy. A transfer, based on future rent expectations, has been made from current real estate owners to those who owned real estate before these policies created rent inflation. If we can ever reverse these policies, pulling rents back down to unconstrained levels, current owners will bear the cost of that policy improvement. Market efficiency means that the costs of these policy errors are sunk costs.

One subtle takeaway from this realization is that the high cost of living in the Closed Access cities applies to both renters and owners. For new residents in these cities, it doesn't matter whether they own or rent. Their after-rent income is low either way, even when they are paying rent to themselves, because owner-occupiers have to forego the opportunity costs of the excess capital they transferred to the previous owners when they bought the unit.

Let's compare four households, based on incomes before and after rent. An owner and a renter from a Closed Access city with high and rising rents, and an owner and a renter from an Open Access city with low and stable rents. For simplicity of comparison, each household will have enough capital to own their units without a mortgage and values are in real terms and excess capital is invested in assets with returns equal to the net return to housing.

The point of this simple exercise is to help think through how, once rent expectations have been internalized in the price of a home, the high cost of rent is imposed on both renters and owner-occupiers. I have contrived the numbers to make the point, but generally these numbers reflect actual incomes and expenses of the median household in the Closed Access cities versus the Open Access cities.

With these contrived, but realistic, numbers, all four households enjoy the same incomes after the costs and capital gains of housing are accounted for. (This example is of a zero inflation economy, so the capital gains accruing to the High Cost owner reflect the realized gains that come from the effect of rising rents on the current value of the home.)

Here is a graph, as a reminder of the extreme and recent nature of this issue. Any time before 1995, there was no systematic relationship between incomes and housing expenses among US cities. (1979 is shown in the graph, but the scatterplot for 1995 is similar.) Then, a handful of cities with vibrant labor markets and sclerotic housing markets suddenly took a dramatic turn, where the Closed Access atmosphere created by those housing restrictions created high local wages which tended to flow to real estate owners. So those cities simultaneously saw a wholly unprecedented level of unusual local incomes and a rising portion of those incomes going to rent.

The table above reflects this problem. And, it does not matter whether the households in these cities are renters or owners. All else equal, incomes equilibrate, regardless of ownership status. My intention here is to use the total returns on savings, including both the house and other investments, as an easy way to understand the opportunity costs of capital, and to walk through how the sunk costs of the high priced home which were claimed by the previous owners lower the income of the high cost residents. Home ownership claimed after high rents were already established is not a way to avoid the costs of high rent. It is a way to hedge future changes in rents and to stabilize future housing costs, but it is not a way to avoid them. In effect, home buyers in those cities are exchanging the risk of rising rents for the risk of changing property values. As I have pointed out in previous posts, the problem created by the housing policies of these cities forces the residents of those cities to be exposed to those risks. Home ownership is just one way to try to hedge those risks. To label home buyers as "speculators" is an error.

In addition to being an numerical exercise in how incomes and expenses accrue to households in these cities, this table also shows how the position taken by the home owner in the high cost city must include capital gains. The expected accrual of those capital gains is a result of the persistently rising rents of the city. So, a household trying to stabilize their future housing costs by taking an ownership position has to lower their relative cash income in order to take that position. The "Housing ATM" is an inevitable outgrowth of the problem of these cities.

The typical characterization of those households as speculators, as reckless optimists using their homes as ATMs, as actors in an unsustainable bid for real estate trading profits, is a massive case of attribution error. This is a sign of efficiency. Efficient real estate markets will naturally settle where these home buyers are taking on some form of risk that is of a scale similar to the risks taken on by renters. The risks here are the risks imposed by Closed Access cities on their residents. The risks come from local policies. If we are upset by the risks home buyers and lenders were taking in the midst of the boom, then we should be just as upset by the risks taken by renters. To focus on either is to blame the grass for a drought. The source of the risk is the cities themselves. Blame the voters. Let's talk about predatory voters. Because, everything that follows when these policies are in place is as inevitable as the grass turning brown.

Monday, December 28, 2015

When I began my study of the housing market, I did not realize the central role of localized supply constraints. So, as I revisit some of my early analysis, I realize that it can suffer as much from aggregation as the sorts of analysis that I am pushing back against does.

One aspect of the boom that I have given some credence is the idea that FICO scores and general borrower characteristics were overstated during the boom because marginal borrowers could tap their "Housing ATM's" to cover up the fact that they were not able to sustainably pay off their mortgages. I don't think the evidence justifies this as a major effect, but it was at least plausible.

But, if we look at the housing market, as we should, as two markets - the supply constrained market and the open market - even this idea loses credibility. Why? Because home price increases were concentrated in a few cities. For home buyers in most of the country, there wasn't an unusual level of home equity to draw on. So, if the crisis was precipitated by the unsustainability of subprime loans, in 75% of the country, those borrowers should have been defaulting well before 2007.

Here is a Fred graph of annual home value changes. This is the S&P/Case Shiller National Index. I have also added the Federal Reserve's measure of aggregate real estate value. This value includes both the increase of existing properties and the addition of new properties, so it tends to run slightly higher than the Case-Shiller measure. But, looking at both, we can see that there is a very long term tendency for homes to gain about 5% per year, over the long run. I have also included a measure of housing leverage (100 minus equity proportion), on the right hand scale.

The housing market in the early 1990s, in nominal terms, was the worst market since WW II. In the late 1990s, prices increased at slightly above trend, though this was mostly mean reversion, and, in the aggregate, households appear to have deleveraged as a result. From 2000 to 2005, there was significant price appreciation that wasn't associated with deleveraging. This is the period associated with the "Housing ATM". This graph probably understates the issue a bit, because in the 1970s and 1980s, when home prices had previously risen strongly, they had risen along with broader inflation. In the 2000s, since price increases were due to housing supply constraints, and not monetary expansion, inflation outside of housing was low - generally below 2% - and the gains to homeowners were real capital gains.

If we imagine a typical household, with income of, say $40,000, and a $150,000 home, the typical year might provide them with a potential $7,500 capital gain. A period of time with 10% housing price appreciation would provide them with a potential extra $7,500 gain. This is certainly enough to provide noticeable cover for a household budget that is in the red.

But, if we look at this by city (below I include the 20 largest MSAs), what we see is that the Closed Access cities had very high rates of price appreciation - generally running above 10% after the year 2000, and sometimes much higher. By 2004 and 2005, 7 or 8 out of these 12 cities saw 20%+ annual price appreciation. These cities really did provide significant gains to owners. *

Outside of these cities, though, the story was much different. The Closed Access (and "Closing Access") cities represent just under a quarter of the US population. Almost all of the remaining three quarters of the country had a different experience. Here is a graph of the Open Cities and the Old Economy cities. Together these represent about 1/6 of US population. But, in this graph, I also included the results for the US, nationally. I have not adjusted this to remove the Closed Access cities, so the US outside of those cities would have seen annual price increases somewhat below the aggregate average shown here. These areas tended to run along the long term 5% trend. Phoenix is the extreme outlier in this group. But, even in Phoenix, the extreme price movements were very late in the boom, so that subprime buyers in Phoenix would not have been capturing very unusual capital gains in the 2000 to 2004 period with which to inflate the appearances of their credit-worthiness.

When we look closely at the disaggregated national data on home prices, clearly most subprime mortgages were made in areas without much of a "Housing ATM" - areas representing about 75% of the population and 85% of housing starts. The creditworthiness of most subprime borrowers would not have been inflated by unusual capital gains. And, if the crisis was caused by the inevitable default of millions of mortgages to unworthy borrowers, there is no reason why those defaults would have failed to show up until late 2007 and after. In these cities, we generally see fairly normal price behavior that suddenly collapses in 2006 and 2007.

All of these cities saw home prices begin to fall in nominal terms between late 2005 and early 2008. There is no reason why the many cities that never experienced unusually high price appreciation should have suddenly experienced price depreciation in 2007 when the rest of the economy was still strong. Home prices and mortgage affordability in most of the country were not high in 2005, yet by mid 2006, mortgage affordability in the Open Access cities was falling, in concert.

If bad credit risks were the reason for the housing bust, then in the 3/4 of the country where there never was an unusual amount of home price appreciation, we should have been seeing higher defaults all along. But, we didn't. Defaults were very strongly correlated with the time of purchase. Mortgages originated in 2006 and 2007 had much higher defaults than mortgages originated in other years, and the higher defaults happened across mortgage types.

Before I was in the habit of thinking in terms of the different cities, it seemed plausible that the falling default levels from 2000 to 2005 were a product of rising prices. But, when we think in terms of cities, this is a strong counter-argument against the credit-driven theory of the bust. Subprime delinquencies were falling throughout the expansion. At most, we could say that the rising prices of the Closed Access areas were pulling delinquencies down somewhat. But, even after making that adjustment, we are left with delinquencies that were unremarkable until the collapse began in 2006 and after. In 2004 and 2005, there was a sharp transfer in mortgage originations from conventional mortgages to subprime mortgages. Those mortgages performed well even though most of them never experienced significant capital gains. But, in 2006 and 2007, suddenly new credit dried up, prices collapsed, and many recent home buyers defaulted together.

There is little reason to believe that, on the national scale, there was a way for rising home prices to completely hide a growing problem of unworthy home buyers. Look back at that first Fred graph. When we remove the demand-side explanations from our story of the housing boom, that extreme and sudden drop in home prices should cause our own jaws to drop with it. We shouldn't have expected it. We shouldn't have stood for it. And, we shouldn't have demanded it. But, we did. When we believe the demand-side narrative, that drop seems inevitable - even reassuring. But, if the demand-side narrative is wrong, then our monetary authorities absolutely had a duty to avoid it. That is what they are there to do. I don't see that as an indictment of them so much as an indictment of our insistence on centralized monetary control. They did what we demanded of them, and it will probably be at least a generation before most observers really question what happened.

* Keep in mind, even in cities where prices were rising sharply, they were rising because of sharply increasing rents and rising expected future rents. Renters in those cities, who don't have a mortgage, are facing rising costs every year. So, a marginal household that uses a subprime mortgage to buy a home may still be taking on the safer position compared to renting, even if they have to tap equity to make it sustainable. If the renter expects to see rent inflation of 5% per year, then a position where they take on a mortgage that either manually or automatically contains a negative amortization of 2% or 3% per year is the safer position, compared to renting. They have become speculators in the local housing market, which requires them to bet that rents will continue to rise (because that expectation is embedded in the price of their home), but this wasn't by choice. This was foisted on them by the reality of their closed access local housing market.

Thursday, December 24, 2015

Here are a few graphs from the Zillow data sets that I have been playing around with. These are for the largest 20 metro areas (MSAs).

First is median income, relative to the US median. Second is median income after rent, relative to the US median. We can see that Washington, DC is an outlier, and actually has been an outlier for some time. The Washington, DC MSA has much higher income than any of the other large MSAs. (If we expanded the list a bit, San Jose would be close.) Washington is also different, in that incomes aren't eaten up by a bidding war for housing. Suburban residential building is strong enough that the median household can find acceptable housing for a typical portion of their income. They might need to make some compromises, in terms of size or location, relative to residents in open access cities like Houston or Dallas, but those compromises aren't so severe that average Washington residents have been driven to allowing their total housing expenditures to increase as a portion of their budgets.

That is not the case among many of the other MSAs. For some cities, incomes before and after rent are similar, but for some cities, incomes after rent are significantly lower than gross incomes, relative to the rest of the country.

The next graph, below these, is a stark picture of the primary source of our 21st century malaise.

As % of Median US Income

As % of Median US Income after Rent

This next graph is an average of median incomes, before and after rent, in these cities (weighted by population). We can see the surge in metropolitan incomes in the 1980s. During that time, rents rose at the same rate as incomes, so income in these cities, before and after rent, exhibited similar behavior. I think some of the problems these cities have with housing were already in play. However, I think they were still in the sort of position that Washington, DC is in today (along with other marginally problematic cities like Seattle). Workers moving to those cities in a bid for higher incomes had to reduce their real housing consumption in order to keep their housing budget within a comfortable range. But, housing supply hadn't yet become so constrained that the median household needed to increase their housing budget just to maintain minimum acceptable housing.

This changed in the late 1990s. After a period of moderating relative incomes, in the mid-1990s, relative incomes in these cities began to rise again. But, now housing constraints had become so strong that the effect of households moving to these cities to tap into lucrative job markets was to force the median household to spend all of their marginal new wages, and more, on rent.

Here we can see signs of several of our economic problems. We can see the sharp effect of the urban housing supply problem coincident with rising prices in the 2000s. We can see rising income inequality, yet with the sense that the typical family can't get ahead. And, putting these factors together, we can see how mistaking deprivation for monetary excess led us to invoke all the wrong attempted solutions, exacerbating the problem of rising costs.

That graph understates the effect, because there has been a divergence of outcomes between these cities over the past two decades, depending on their local housing policies. In the next graph, I compare these same measures between what I call the Open Access cities and the Closed Access cities. In the Open Access cities, where the Housing Starts portion of the housing boom took place, relative median incomes after rent are higher than relative incomes before rent. Where housing starts were high, there was no unsustainable increase in housing expenditures. Those housing starts mostly were facilitating the in-migration of households from the Closed Access cities - households which tended to skew to lower incomes.

In the Closed Access cities, where the Home Price portion of the housing boom took place, relative median incomes after rent have been low for many years, and beginning in the late 1990s, began to diverge from gross incomes even more. Where housing constraints are severe, home prices were boosted by sharply rising rents. The housing bust made this problem much worse. Now it looks like cities representing around 15% of the country's population have incomes around 25% above average, but all of those above-average incomes are being eaten up by housing expenses. (Even for owner-occupiers, this represents an opportunity cost of their capital.)

Tuesday, December 22, 2015

So far, it looks like we have dodged a bullet. Since the zero lower bound probably causes distortions even in forward rates, I thought there was a chance that when the rate hike was implemented, pulling forward rate expectations up off the zero lower bound, it would be associated with a relative decline in forward rates. So, either there was no distortion as I had speculated that there might be, or the change in the distortion had been priced in before the hike announcement, or forward expectations are strong enough to counter it.

I think the next concern to watch for is the discovery process as credit markets react to the higher interest rate on reserves. If the rate hike has created a contractionary response in currency, bank credit, or excess reserve levels, we will learn this over time, and I would expect forward rates at the terminal end of the yield curve to decline. Trends in mortgage lending are probably more important than any of this.

In this graph, we can see that when the Fed backed off its rate hike plans in the first half of 2015 and the economy looked reasonably strong, the rising portion of the yield curve moved forward in time, in conjunction with expectations, and the monetary accommodation led to a general rise in the terminal end of the yield curve. I would have liked to have seen the rate hike moved back to March or June. I would hope that continued patience from the Fed would have pulled the long end of the curve up to 4% or 5%. That would be normalization, if that's what we are going for.

But, as the Fed held firm on a 2015 rate hike, the long end of the yield curve fell back to the 3% range. The confirmation of a hike pulled the short portion of the curve up slightly, but the terminal value at the long end remained around 3%. The top end hasn't moved much since early October. I think this is probably the thing to watch now, but I don't have any opinion about the direction it will go. If the Fed starts pulling in more reserves and the long end of the curve begins to fall, then that seems like a strong sign that the Fed needs to reverse the hike.

If mortgage credit expands and the long end of the curve moves up, then I think we may have recovery for an indefinite period of time.

Monday, December 21, 2015

Dean Baker at CEPR has a new working paper out on economic rents and income inequality. It is heartening to see Baker continue to confirm the finding that increasing income variance has been mostly a function of wage variance, not a function of labor vs. capital shares. This has led him to a position that I think can really gather a consensus from many parts of the political spectrum, which is that properly regulated and functioning markets are the solution, not the problem. The working paper focuses on patents, financial sector rents, executive compensation, and barriers to entry in the skilled professions. Of course, I would place housing constrictions front and center on that focus (and I would also explain the recent decline in labor share of national income that we do see, with housing constraints), but that doesn't matter nearly as much as the acceptance of the fundamentals here. The "negotiating power of labor vs. capital" explanation is very satisfying, from a progressive point of view, and I give a lot of credit to Baker for following the evidence here, even as it points away from that explanation. Credit is especially due, because it would be easy enough to conflate the recent decline in labor income (which is due to housing) with the long-term stability of labor share of national income, to claim, mathematically, that it is a labor vs. capital story. The fact that Baker has resisted this easy-enough interpretation for the more subtle, and (I think) accurate interpretation is commendable.

Here is his concluding paragraph:

The implication of this argument is that progressives need not think of themselves as using government against the market. Rather they should seek to find ways to use market mechanisms to bring down the incomes of the wealthy in the same way that wealthy have sought to structure markets to lower the income of everyone else. The market should be viewed as a tool. It makes no more sense to rail against the market than to argue against the wheel. Progressives place themselves at an enormous disadvantage if we are not prepared to use this tool as effectively as possible to advance progressive ends.

Low barriers to the application of new, competitivecapital is the primary cause of the material improvement of the common person. If we can re-establish a consensus on this point, along with the realization that prices (including incomes) are information, and if our efforts are directed at changing the inputs (functional and accessible safety nets and credit, health, education, and housing markets) into that information instead of being directed at forcing a change in the outputs (price and wage pegs, redistributive taxation, and subsidies), the remaining disagreements are trivia.

Friday, December 18, 2015

Random aside: Isn't it strange how the Fed and other observers are referring to the implementation of a completely novel approach to raising interest rates by using interest on reserves as "normalization" of monetary policy?

Tuesday, December 15, 2015

In financial analysis, one of the lures of technical analysis is hindsight bias. When we look at a historical graph, and we can see when trend reversals happened, it is very easy to imagine that we could tell in real time that they were about to happen. One test I like to perform on claims of technical indicators is to simply cover a graph up, and slowly reveal its movement over time, and to try to predict the trend changes that the indicator is supposed to reveal. Most of the time, it fails.

But, we see an indicator with peaks and valleys, and our minds are very easily convinced that every time the indicator gets "too high" we will be able to forecast its collapse.

Here is a variation on that theme (HT: Todd Sullivan). At any given time, there are thousands of warnings floating around about how a market collapse is around the corner because margin interest levels are getting too high. They include graphs like this.

And, it seems pretty clear, looking at this graph, that high margin debt is a sign of overheating markets and a coming correction.

But, as Econompicdata points out, margin debt mostly just scales with equity values.... Of course it scales with equity values. What would we expect? Someone using margin debt as a cyclical indicator is basically just noticing that stocks tend to move up and down through business cycles. Usually, if you start getting nervous a few years into an expansion, you don't have more than a few years to wait to see another correction, so if you are primed to associate corrections with "overheating", this pseudo-indicator will seem prescient.

There has been a lot of recent discussion about macroprudential regulation. It kind of surprises me that in the year 2015, there seems to be a plurality in agreement that committees of technocrats can save us from ourselves. Don't most informed people agree that a buy-and-hold passive investment strategy is the only rational option for the typical amateur investor (and most professional ones)? If we support macroprudential regulation, shouldn't we believe that the committees in charge of that regulation could help us out-perform the market, by alerting us to excesses? Is there anybody out there writing articles for financial journals where they find persistent anomalies where the actions of political appointees systematically disprove the Efficient Market Hypothesis?

Here is a recent article from the Wall Street Journal about one avenue of this new regulatory push - leveraged loans (HT: Evan Soltas). I don't see any evidence here that this is anything different than the margin debt indicator. What's worse, if some of our cyclical economic variations are due to pro-cyclical federal policies, then imagine what damage we are doing when we analyze business cycles and conclude that what we need to do is pull back on the reins sooner and harder. Just for the sake of argument, imagine with me what that means if, in fact, pulling back on the reins has been our primary problem?

From the article:

“We learned a lesson” from the financial crisis, says one former regulator who pushed for a crackdown when leveraged loans surged in 2013 and standards slipped. “You can’t wait.”

Um...2013? Isn't the fact that we clearly didn't have an "overheating" episode in 2013 sort of a mark against this view? Can evidence defeat these proposals?

In some ways, the reining in of leveraged loans goes all the way back to 2006, when the Fed, OCC, and FDIC cautioned that they had noticed “increasing credit risk” in a rapidly growing part of bank loan portfolios . . .
But demand dried up when the financial crisis erupted. Citigroup suffered losses of $5 billion on its leveraged loan portfolio from mid-2007 to mid-2008. Across the industry, large lenders got stuck with more than $300 billion of leveraged loans and commitments they couldn’t sell.

Why do we assume that the problem was the proliferation of activity in 2006, and not the collapse in demand in 2007? Just as with the margin debt above, it seems to me that there is a sense that what goes up must come down, and the eventual crash justifies our pessimism. This is similar to the housing market, where a collapse was related to the worst economic crisis in generations, yet those who were calling for a bust still feel vindicated. The suggestion that we should have tried to avoid this disaster is usually met with an indignant retort about kicking the can down the road toward an inevitably worse correction.

But, we don't have to imagine a counterfactual. Several countries shared the "bubble" but not the bust, and those countries are generally doing ok - Canada, Australia, etc. They shared in the global downturn, but they managed to do it without having double-digit delinquency rates on mortgage debt or a decade-long collapse in housing starts. That's a pretty good first estimation of our counterfactual. The consensus view in this country, as far as I can tell, is that it was good that we experienced the worst economic crisis in decades so that we wouldn't be in the terrible position of maybe, possibly, having a correction in the future. If anyone thinks that makes sense, then I suggest you take out large short positions on the Canadian and Australian economic markets. Because, if they even have a chance of eventually being sorry for having avoided the housing bust so far, they are in for one doozy of a collapse. We have a whole decade's worth of stagnation in the housing stock that they have supposedly kicked down the road.

Some veteran regulators, including at the Fed, wanted to issue general guidelines and leave lending decisions up to the market, say people who participated in the discussions. If banks were selling the loans to willing investors, these regulators thought, then federal agencies shouldn’t intervene.

Other regulators were adamant about the need for a single, specific underwriting standard for all loans. They recalled how the Fed, OCC, and FDIC had published joint guidelines for risky mortgages in 2006 and 2007, but that was too late to ameliorate or avert the housing crash.

Adamant about the need for a single, specific underwriting standard for all loans! This is how we are going to be prudent - by enforcing a single standard on the entire market. Who thinks that a monoculture is robust? Where is this coming from? And, those joint guidelines for risky mortgages in 2006 and 2007? Were they really too late to avert a housing crash, or were they just in time to feed one?

I want to take a step back here, and think about ownership stakes in productive assets. These are roughly divided between debt and equity. Equity holders tend to accept the cyclical risk in exchange for a premium, or seen from the other side of the trade, debt holders accept a discount on their expected income in exchange for more certain cash flows. As with most economic issues, there are supply and demand factors here that pull in different directions. If investors are looking for more risk, they will tend to buy equities. So, while financial intermediaries might feel more comfortable taking on leverage during an expansion, I think the idea that there is a pro-cyclical debt cycle is a little overblown. It's a bit like those margin debt graphs - there is less there than meets the eye.

Here is a graph of total debt and household debt, as a proportion of GDP. I don't see any cyclical behavior here at all. If we want lower levels of debt, then cyclical macroprudential oversight isn't what we should promote. Instead, we should stop favoring debt in secular tax and regulatory policies.

Here is a graph with several measures of corporate leverage. Since equity values suffer the brunt of cyclical fluctuations, here we see that after a contraction, corporate leverage increases as a result of falling corporate asset values. But, going into contractions, at least during the Great Moderation period, leverage has been level or declining.

The red line is debt/equity market values. With this indicator, we can see how low equity values were in the 1970s, when interest rates and inflation were very high. Inflationary monetary policy sharply reduced asset valuations. Then, as inflation and interest rates have declined, firms have reduced their leverage, as measured by market values. When contractions hit, leverage jumps out of equilibrium, and during expansions, firms generally have been pulling leverage back down as equities recover.

The blue line is a similar measure of leverage, using net worth instead of market value for equities. If we worry that equities are becoming over-valued during expansions, causing the red line to understate leverage during expansions, this would correct for that. Yet, we still see a long term decline in leverage since the early 1990s, as interest rates have fallen, and we still see counter-cyclical deleveraging during expansions.

Finally, the green line is a measure of debt / operating profit. In this measure, we see a one time bump in the mid 1980s to a higher level, and a level trend since then. This looks like it has a pro-cyclical pattern, but the purple line is a measure of corporate operating profits, and we can see from this that the apparent cyclicality comes from a drop in operating profits, which is a leading indicator of contractions.

Taking this all together, the one factor here that contributes to an increase in leverage going into a contraction is a decline in corporate profits. The argument against managing nominal incomes in a way that might support corporate profits generally revolves around the idea that this encourages risk-taking and leverage. But, there is no evidence here that there is any unusual rise in debt as expansions age. If anything, we see the opposite trend.

This is basically the broken window fallacy applied to monetary policy and financial regulation. We have to keep breaking windows so that nobody starts assuming that their windows won't break. I would call this financial asceticism, and I would prefer not to be forced to practice it.

Here are my updated charts. Not much to say. Both shelter and non-shelter core inflation continue to move in the same ranges that they have seen for the past couple of years.

Considering these levels, the expected rise in the Fed Funds Rate is a bit troubling.

As I have mentioned before, interest rates may not be that important. Now, raising rates will have some disinflationary effect, so there is a danger here. But, housing is our constraint now, both on real production and on inflation. As important, or more important, than rates, within some range, is the expansion of mortgage debt outstanding.

There have been false starts before, but recently it looks like mortgage levels have begun to expand again. So, I still have some hope that some force is leading to mortgage expansion - whether that is regulatory, or from development of unconventional mortgage funding sources, or from continued recovery in home equity. Maybe this can save us from ourselves.

Saturday, December 12, 2015

Any IW readers have an explanation for this? I'm perplexed. Keep in mind, your explanation needs to explain why the uptrend goes back to 2012 and why there was a sharp uptick in late 2014 and why the higher level has persisted for a year, with recent strength.

Friday, December 11, 2015

Tom Clougherty, at Alt-M, builds on George Selgin's great post on the Fed's peculiar behavior in 2007 and 2008, where they sterilized their emergency lending activities by selling treasuries, which had the effect of creating tight monetary conditions. He references this interesting piece at Cato, from Daniel Thornton, who was an advisor at the Federal Reserve Bank of St. Louis before he retired in 2014.

But, as much as I applaud how each of those pieces pushes back against both the idea that the Fed was accommodative in 2007 and 2008 and the idea that QE operated through the reduction of long term interest rates, I still see a tendency to fall back into some of the same assumptions. From Thornton's piece:

If the Fed distorted asset prices between June and December 2003, one can only imagine what the FOMC’s zero-interest-rate policy over the period December 2008 to the present has done. And, of course, Kohn is correct: the intention of the policy is to distort asset prices in an attempt to reduce long-term yields. But such actions produce unintended distortions: a strong and persistent rise in equity prices, a marked change in the behavior of commodity prices, a resurgence in house prices and residential construction beyond what is warranted by economic fundamentals, and excessive risk taking, even by those who are least well situated to take it. These are the unintended consequences of QE and the FOMC’s zero-interest-rate policy.

I have written extensively in my ongoing series about how home prices were not high in 2003 because credit or artificially low short term rates had pushed them above levels justified by fundamental valuations. I am pleased to see momentum in opinions about monetary policy that points out the hawkish policy decisions they were making before and during the financial crisis. But, the idea that home prices were unjustified is so powerful and so palpable, that even in the midst of these questions, questioners tend to accept whatever assumptions are required to conclude that the housing and equity markets were overvalued because of monetary policy. Thornton, for instance, in his article, sharply questions the idea that low long interest rates reflect expectations of loose policy that creates persistently low short term rates. I agree with him that that model seems incoherent. But, when it comes to explaining rising equity or housing markets, he seems surprisingly willing to accept that model.

I understand that this is difficult. The idea of a housing bubble seems unassailable. To attempt to argue against it would be reputationally risky - certainly too risky to entertain the idea in a sort of back-of-the-envelope initial line of questioning. I believe that the reason I might get to be a voice in popularizing the idea that there wasn't a bubble may be because I have done such a smashing job of avoiding having any reputation to ruin.

So, in a way, the intellectual barriers to my narrative are strong. Yet, on the other hand, Clougherty, Selgin, and Thornton have already accepted the fundamentals of my narrative in other contexts, so they don't need to be convinced to change their fundamental beliefs; they just need to be convinced to apply them more thoroughly.

I have plenty of posts in the housing series that go into the details of housing valuations. In this post, I want to mention equities, because the same sort of assumptions seem to be feeding ideas about equities. Most observers seem to attribute rising equity prices to monetary accommodation, credit expansion, and "reaching for yield".

Most analysis of equity pricing behavior uses price movements or total returns over a period of time. I think this conflates income, capital gains, expected returns, and real shocks, and leads to a lot of confused analysis. I believe that if we look only at expected (or "required") returns on equities, we find a surprisingly stable real implied yield on corporate equity over long periods of time. Aswath Damodaran at NYU has developed an extensive data set of variables that allow us to analyze equity values back to 1960.

In English, the required expected return on an equity is equal to the risk free return plus an equity risk premium. For individual stocks, this premium would scale with "beta", which is the sensitivity of that stock to volatility of the broader market. The market, by definition, has a beta of 1, and I generally prefer using 10 year treasury rates as the risk-free rate that is most relevant to equity values. So, for the market as a whole, expected returns are simply the sum of the risk-free rate and the equity risk premium.

For returns on bonds, all we need to know is the coupon, because cash flows are fixed and expected inflation is paid as a portion of the interest rate. (A 5% bond might be earning, say, a 2% real yield plus a 3% inflation expectation.) But, equities (and homes) are real assets, so cash flows rise over time with inflation or real growth. This means that to estimate the equity risk premium, we need to estimate the expected growth in cash flows. For equities over the long term, this is the expected growth of net profits.

One problem we have with this question is that we have only had market rates on real bonds for about 20 years, so before the late 1990s, it is very difficult to separate inflation expectations from real growth expectations. But, to the extent that we have data, I interpret Damodaran's work to be turning the CAPM on its head. Real expected returns seem to be very stable. Most of the changes in equity prices come from real shocks to corporate earnings and changes in growth expectations.

This means that "reaching for yield" does not describe market behavior. And it means that if accommodative monetary policy is pushing market prices up, this is probably a sign that policy had been too tight, and accommodation is improving the broad prospects of the real economy.

Here is a graph comparing the required returns to equity (ERP + risk free rate) to treasury bond rates since 1961. There are basically two eras here. Before the mid-1990s, real rates fluctuated somewhat, but they were swamped by fluctuations in inflation. This makes it appear as if ERP required returns on equities and risk free rates move together. But this is confusion. Equities (and homes) are real assets but treasury bonds are nominal assets. Required returns to both are sensitive to inflation. But, if expected real returns to equities are fairly constant over time, this means that when risk free rates rise, ERP would tend to fall at a similar scale. When fluctuations in inflation are large, the positive relationship regarding inflation covers up this inverse relationship regarding real returns.

Since the late 1990s, we do have markets for real risk free rates. But, inflation had settled down enough by the late 1980s that we can get a pretty good estimate of real rates back to at least 1990, simply by subtracting inflation from nominal rates. Here I have used the GDP deflator as the inflation proxy. So, we have the era before 1990 where fluctuations in inflation dominated, and we have the era since 1990, where inflation has been fairly stable and real risk free rates have dominated. This means that during this period, if required total returns to equity are, indeed, stable, we should see a negative relationship between ERP and risk free rates.

Here is a scatterplot of ERP and 10 year risk free rates (minus inflation) since 1989, together with the scatterplot of ERP with the market rate on real 30 year bonds since 1999. Here we see this strong inverse relationship.

Since 2008, Damodaran has estimated ERP on a monthly scale. Here is a graph of monthly total required returns on equities (risk free rate + ERP). After the disastrous events of September 2008, there was a brief bump in required returns to about 10%, which subsided back to the stable 8% nominal level by the summer of 2009. So, the brief deep plunge of equity values that bottomed out in March 2009 was part of a brief shock away from the typical required level of returns. But, later in 2009, required returns simply moved back to their normal range, and none of the subsequent gains had anything to do with "reaching for yield". They have mostly reflected real recovery of nominal spending and corporate earnings.

Here are scatterplots, using market rates on TIPS bonds, of monthly ERP since September 2009, compared to both 10 year and 30 year real interest rates. Again, we see a strong inverse relationship.

This suggests that changes in long term real interest rates have little or no effect on equity prices. The ramifications of this are stark. This means that gains in equity markets should be taken as a sign of optimal monetary policy. To the extent that policy makers are calling on monetary policy to tighten up in order to rein in "overheated" asset markets, they are literally calling for monetary policy to tighten up until it has damaged broad, real economic growth. Loose money or low rates do not cause equity markets to "overheat". Even if monetary policy is inflationary, this will not lead to persistent increases in equity values, because the stable required returns on equities are real returns, not nominal returns, so equity prices should be unaffected by inflation expectations in the medium to long term. And, clearly, when monetary policy was overly inflationary in the 1970s, stock prices were tempered.

This also speaks against the idea that low interest rates are related to leveraged corporate risk-taking. If corporate assets have a stable discount rate, then low real interest rates should be taken as a much stronger signal of risk aversion - not risk-taking. And, I do believe that this error in interpretation is one of the elements that led to the misidentification of high home prices with speculative over-reach.

Home prices do behave differently than equities, though. Cash flows and discount rates on homes are more similar to real long term bonds, so home values can move up when long term real interest rates are low. In my next post, I will return to that topic, with more of my analysis of how even that effect would be mitigated in the absence of the supply constraints which were the primary cause of home price appreciation in the 2000s.

PS: These are the scatterplots above, using 1 year or 1 month changes in ERP and real risk free rates unstead of levels. ERP is a necessarily noisy estimate, so first differences have low correlations, but the coefficients are still surprisingly strong.

PPS. On second thought, these scatterplots of the first differences may be adding more heat than light, since inertia in equity prices, and earnings and growth estimates, would naturally lead to an inverse relationship in the short term.

Tuesday, December 8, 2015

I have posited that housing supply constraints for the past two decades have led to supply-side inflation, and that our inflation indicators have been conflating two factors: (1) monetary inflation, which may be reflected by core CPI inflation, excluding shelter, and (2) supply-side inflation, which is reflected by shelter inflation above that core CPI ex. shelter level. The supply-side inflation represents rents that are transferred to existing real estate owners as supply constrictions lead to rent inflation. These transfers are picked up in the data as inflation, and are erroneously attributed to expansive monetary policy.

If one accepts this idea, then I think TIPS markets are giving a pretty strong signal that markets expect either a deflationary shock in the next few years or a Japan-like situation going forward, where core inflation is negligible. Here is a graph comparing the 5 year inflation expectation implied by TIPS bonds to the Shelter portion of CPI inflation (Shelter inflation x its weight in the CPI calculation). I don't think the bottom is going to drop out of labor markets in the next three months, or anything, but this seems like a striking picture as we expect an imminent shift to rate hikes.

PS: Here is the difference between these measures. Note how 5 year inflation expectations minus Shelter inflation declined in 2006 when the housing market first began to sputter, then began to recover when the Fed Funds Rate was finally allowed to decline in late 2007 and early 2008, then collapsed when the Fed prematurely held rates up at 2% in 2008, then bumped up with each round of QE, only to decline again after each QE was tapered or ended, until now, where forward inflation outside of shelter inflation is negligible.

Monday, December 7, 2015

George Selgin has a great review of monetary policy in 2007 and 2008 and the policy of sterilizing their emergency lending activities. I think that is a good example of how the consensus opinion that the housing market was overheated because of excess lending was a foundation of the coming recession. The Fed was so scared of giving any support to credit markets that even when there were clear signs of distress, even when they were engaged in activities that are normally associated with a need for liquidity, they were actually tightening their stance in order to make sure that credit markets didn't expand.

I think the issue Selgin is pointing to here is clear evidence of the tight policy stance that goes back to at least 2007, and arguably to 2006, that predates the collapse of housing markets. The Fed refused to support credit markets, growth of mortgages and housing starts began to drop, and then eventually, home prices began to drop. The tightening preceded the collapse in home prices.

Selgin, along with David Beckworth and Berrak Bahadir recently published a paper that built on the idea that loose Fed policy from 2003 to 2005 was to blame for the housing boom. In that paper, they point to NGDP targeting as a preferred tool for monetary policy. A 5% growth rate is sometimes discussed as a target. This is an arbitrary figure, which is lower than NGDP growth rates in any expansionary period since the establishment of the Federal Reserve. Compared to this target, NGDP growth of 6-7% in 2004 and 2005 was slightly high, and began to fall slightly below target in 2006, eventually collapsing in late 2008. But compared to historical norms, I don't see any obvious case for describing the 2000s as a period of monetary excess. NGDP growth was mild, core inflation was low, currency growth was lower than it had been for decades, and credit growth was within ranges seen over the past few decades.

It seems to me that the idea that high home prices were a signal of excess demand carries a lot of weight. To the extent that the home price boom and the home building boom are two geographically separate events, and that home prices were driven by supply factors, not a deviation from reasonable cash flow expectations, it seems to me that there is very little left to describe the 2000s as a period of monetary excess. But, George Selgin now sees the Fed sowing the seeds of nominal contraction as far back as, at least, 2007. I think this pulls him most of the way toward the conclusion that Fed behavior after 2006 was much more important than Fed behavior before 2006.

It seems like the supply story on homes before 2006 and the type of work Selgin is pointing to here, regarding Fed management as the boom plateaued, serve to begin to create a complete narrative of the period. At its base, there are continuing, sharp political impediments to building in key cities. This calls for high home prices in those cities. Lending monetary accommodation facilitated those rising prices, as well as building in areas where households were moving to escape those excessive costs. In this way, we could say that excess demand caused a "bubble". But, solving the housing problem through demand means explicitly undermining demand so thoroughly that home prices move out of a rational expectations range. There is a strong sense of defending the demand story, but once one accepts supply constraints as the source of the problem, managing the boom by undercutting demand seems indefensible to me. Would it have been better to undercut demand earlier so that housing supply would be even lower? Until the supply problem is solved, cost of living in the constrained cities will induce stress on median household budgets, regardless of NGDP. Those stresses will persist if higher national incomes draws high income households into those cities, driving up rents. Lowering the nominal incomes of those stressed families obviously does little to help this problem.

The problem isn't high home prices, it's high rents. Rents aren't high because of a housing boom.

P.S. And while cheap homes in Texas isn't the optimal solution to the problem faced by middle income families in California and New York City, removing that option, which is mostly what we have done, is obviously counterproductive.

Wednesday, December 2, 2015

I have previously looked at home values, on a city-by-city basis, with the idea of comparing price levels to rent inflation. If a city has had persistently high rent inflation, then an expectation of future inflation should cause home prices in that city to rise. This is based on the basic financial formula for the present value of a perpetual cash flow:

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For houses, without constraints to supply, we would expect rent to roughly grow with inflation over the long term, and we can estimate net cash flows after depreciation, property taxes, and expenses, so that net cash flows reflect a perpetual stream of rents on a home with a stable value. So, this equation simplifies to Price= Net Rent (after expenses and depreciation) / Real Long Term Interest Rates. But, in several cities, political constraints to new building have developed, such that there is persistent rent inflation, above the general rate of inflation, so there should be a premium in those cities on real estate prices which is related to that growth rate adjustment in the denominator.

If Net Rent/Price is less than the normal discount rate, that implies expected rent inflation. Low Rent/Price is the inverse of high Price/Rent.

So, anyway, I did that calculation in the earlier post, but I have been thinking about the discount rate. I had used 30 year mortgage rates as a proxy for the housing discount rate. But, I have decided the most of the temporal changes in the mortgage spread are related to cyclical and secular changes in expected pre-payments, so that it actually doesn't make that great of a proxy for required market returns to home equity.

Here is the graph of what the breakeven expected excess rent inflation looked like using the mortgage proxy. But, the expected inflation from the 1990s seemed too high, and I have come to the conclusion that that is because mortgage rates of 7-8% created more pre-payment risk, causing the mortgage rate spread to rise in a way that shouldn't affect returns to home equity.

Maybe, the best proxy is simply long term treasury bonds. There is a 30 year TIPS (real, inflation adjusted) bond that goes back to 1998, and I have inferred it back to 1995, since that has been the benchmark date I have been using as the beginning of the current problem. And, as I have shown in several graphs, for the short time we have had TIPS bonds, long term real treasury yields and the aggregate average implied yields on homes moved together well, as we should expect (until disequilibrium happened in 2007).

It is possible that for owner-occupiers, there is not a 1-to-1 mathematical reaction of price to long-term rates, as there would be with bonds. One reason would be tax benefits to home ownership, the largest of which is the non-taxability of imputed rents. Landlords must pay taxes on their net rental income, but homeowners do not, because there is no cash transaction. This benefit would be proportional to the rental income - that is to say, proportional to the implied real yield. In addition, the tax deferral and tax exemption benefits of capital gains would also be a benefit to homeowners. This benefit would be proportional to the inflation premium portion of nominal long term interest rates.

Here is a graph comparing four time series. The orange line is excess Trailing One Year CPI shelter inflation above Core Inflation. In an unconstrained market, this should have a mean near zero. The green line is the rent inflation required to justify home prices if we assume a required real yield on homes that is unresponsive to interest rate changes. It is fixed at 3.3%, which is the 65 year average. The blue lines assume that 1995 aggregate home prices require no expected excess rent inflation. The light blue line shows the expected excess rent inflation that would have been required to justify home prices over time if home yields track long term real treasury yields. The dark blue line assumes that owner-occupiers require a yield equal to 80% of long term real treasury yields, reflecting tax advantages of owning, plus a constant 1.4% yield premium, reflecting things like liquidity and non-diversification. The net effect is to make home prices less responsive to changes in the real yield.

I think actual market behavior in equilibrium, is probably similar to the dark blue line. One could play around with the specifications, but the range of expected rent inflation that reasonable specifications would suggest, on the national aggregate level, even at the top of the market in 2005, is within the range of rent inflation that has been persistent.

In the previous posts I had reproduced graphs for individual cities. I am not going to reproduce those here. Relative rent expectations between cities would be the same.

But, thinking through this, I think I have turned away from the intuition I was following way back when I started this series of posts. When I started the series, I had kind of figured out that most of the change in home prices was due to the rise in actual rents plus the sharp decline in real long term interest rates. I suspected that the remaining portion of the rise in home values was due to increased demand because low interest rates lowered the barrier to ownership, increasing demand and lowering the "alpha" that comes from limited access to an asset class. (Here's an old post with a visualization.) And, I suspected that tax benefits that accrue only to owner-occupiers added to the destabilization of the bust by creating a price gap between owner-occupiers and potential diversified buyers that might have been able to fund homes outside the retail mortgage market.

Where I thought I had a novel approach was in identifying the low long term interest rates with tight monetary policy instead of loose monetary policy. Monetary policy is generally thought to work through short term interest rates. Long term rates, especially those that would effect values on a perpetuity like a home, are a different matter, and the secular trend of lower long term real rates may be mostly unrelated to monetary policy. In addition, a long term secular trend of tight monetary policy since the 1970s means that the inflation premium embedded in long term nominal rates is also low, because inflation expectations are low. So, I thought, "Ah, ha!" persistently tight money caused demand to push home prices up because it lowered long term interest rates mainly through lower inflation, but also possibly by lowering real rates. This led to creative lending policies, because the monthly payment was very manageable, and households with little savings could trade an easier down payment for a slightly higher monthly payment. In a high inflation, high interest rate environment, the monthly payment is the constraining factor, so previously, during loose monetary eras, like the 1970s, households weren't enticed into that trade-off.

But, I have become convinced that this demand-side factor is small. Some reasons:

1) From the early 1960s to the late 1970s, we moved from a low inflation context with moderate real interest rates to a high inflation context with low real interest rates, and Price/Rent levels rose dramatically. Unfortunately, I don't know if there are good enough proxies for very long term real interest rates to do a precise quantitative analysis, but it seems clear that regarding home prices relative to rents, intrinsic value (net rent/market value) dominated over demand-side constraints (unaffordable mortgages).

2) Viewed a certain way, point #1 can be missed. There is a decent correlation between home prices and mortgage levels, but the correlation could go either way. Since there is some correlation between nominal interest rates and real interest rates, it is easy enough to imagine that the causation runs from mortgage rates, through buyer liquidity, to higher demand, and finally to high prices. But, the causation could run from low real rates to higher intrinsic values to higher market prices to higher mortgage levels. Point #1 seems to be strong evidence in favor of the second direction of causation - the efficiency story, not the liquidity story. Since 2006, we have been running a sort of natural experiment. We have put strong limitations on mortgage credit. The characteristics of typical approved borrowers have shifted well above normal levels; homeownership has declined sharply; mortgages outstanding have been declining or level for a decade; the private securitization market which had grown to 20% of the mortgage market has all but disappeared.

I think this has been a sharp enough dislocation upon the way our home buying markets normally operate that it has pushed home values below an efficient level. Homes now do provide "alpha" as an investment, relative to the values they have had compared to real long term interest rates in the past. And, yet, the power of the intrinsic value of future rent payments, discounted at current (low) rates, is pulling home prices up, even relative to rents. The current drag on mortgage availability is unprecedented, it should be much stronger now than the effect of marginal changes in nominal mortgage rates. If prices can push toward efficiency in this context, the effect of changing nominal rates in normal markets must be quite weak.

In this graph, we can see how growth in mortgages and changes in Price/Rent ratios tended to move together, appearing to suggest a correlation, before 2007. But, since we have decoupled mortgage availability from mortgage rates, this correlation has broken down. Price/Rent is rising now, even though mortgages outstanding have not been. The correlation between mortgage availability and home prices was spurious. Low real rates cause high home values, which leads to rising home prices and, when we allow it, rising mortgage levels.

Some might argue that the Fed has been accommodative and that QE money has been propping up the housing market. I would agree, to an extent, that QE probably helped markets overcome the stagnant mortgage market. But, it seems that QE didn't work through the expansion of mortgage credit, and if it worked through broader avenues, we would have seen broader signs of inflation. Also, if Fed policy has been accommodative and targeted at housing, it is strange that housing starts have been so low - and they have been incredibly low for a long time. I would argue that a model of the housing market that suggests home prices are high right now (which seems to be a popular sentiment) would have to be a model that gave little weight to demand-side factors like credit availability. Yet, it seems to me that most observers are claiming that home prices are high right now for demand-side reasons. The efficiency explanation seems more reasonable to me, considering these various peculiar pieces of data.

3) The tax benefits of homeownership (mostly related to the non-taxability of imputed rent and deferred or exempt capital gains) are proportional to inflation rates. So, when nominal rates are low, the effect of taxes on intrinsic values will be less and when nominal rates are high, the tax effect will make intrinsic values higher. This should mitigate any demand-related effects in the other direction. For instance, consider that creditors had to pay taxes on the interest income in the late 1970s, even though most of that income was simply a reflection of inflation, but home buyers did not have to pay taxes on the imputed rental income that was rising by more than 10% per year. From an intrinsic value perspective, this would be a strong draw into home ownership, and provides a further explanation of high home prices in the face of disruptively high interest rates due to inflation.

4) We should not forget that characteristics of homeowners during the 2000s boom were stable. The evidence suggests that homebuyers were not utilizing credit markets during the period of expansion to increase their demand for housing, in terms of rental value.

5) During the boom of the 2000s, increased intrinsic values from changes in real interest rates and existing rent levels explained 2/3 of nominal home price increases. The city-specific data on Price/Rent levels suggest that most, if not all, of the remaining price increases were related to expected persistent rent inflation. Of the 130% in average price increases from the mid 1990s to 2006, very little, or none, of that price increase requires a demand explanation.